What is residual income and how does it work?
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Finding (or wishing you had) some funds left after tackling all your monthly expenses? If you’ve been brushing up on tips for healthy personal finance, you’ve probably seen the term residual income.
Although residual income (RI) can mean different things, in personal finance it refers to the income you have left over after paying outstanding debts.
Below, we’ll focus on RI in personal finance and how growing yours can put you in better financial shape overall.
Residual income vs. passive income
RI and passive income are easily confused terms, but the two are actually completely different from each other.
RI (in personal finance) is your leftover income after paying off your debts. So it’s not actually a form of income—it’s more of a calculation for determining how much money is left after paying what you owe.
Passive income is money earned in a way that doesn’t require constant, active involvement. The most common example of passive income is owning a rental property, but it can also refer to money earned from a partnership or business venture in which with little or no effort is required of you.
If you rent a property to someone else, the rent they pay you is income. Because you can collect it without spending a lot of time at the rental, it’s considered passive income.
So while some RI may be from passive income sources, passive income isn’t always residual.
Residual income in personal finances
RI is key to staying on top of your personal finances, especially when it comes to debt management. Another commonly-used name for RI is discretionary income, meaning it’s money that you get to decide what to do with.
Once you know what your RI is every month, it’s easier to grow it over time by not overspending and putting it toward outstanding debt.
How do banks and lenders use residual income?
Increasing your personal RI gives you more financial security and can also help with qualifying for a loan. Because your personal RI shows banks and lenders how much extra money you have each month, it’s one of the main factors banks and lenders look at when deciding if they want to approve your loan.
If you get approved for a loan, you’ll have to pay it back with interest. To do this, you’ll need money that’s not already dedicated to other expenses. Banks and lenders use your personal RI to see how easy (or how difficult) it will be for you to pay back the loan, or what’s known as determining your creditworthiness.
If you’re able to show a high RI, you’re more likely to be approved for a loan. Whereas if your RI is low, then the bank or lender may question your ability to pay back the loan using the amount of extra money you have on hand every month.
Paying attention to your RI is important, regardless. But if you can grow your RI over time, you can put yourself in even better shape when it comes to long term financial benefits.
Increasing your residual income
The only ways to raise your RI are to decrease your debt or increase your income, which we know is easier said than done.
The first step is tracking your current outstanding debt. What loans are you paying off right now? Car payment? Credit card? Make a list and regularly monitor all your debt, while paying attention to how much of your monthly income goes towards it.
Once you feel like you understand your debt, check to see if there’s a way to pay off any of it faster. Can you make larger monthly payments or lower your interest rate? Lenders are usually happy to talk to you about your loan options, so it’s always worth a call to ask.
Do you have many sources of debt that seem impossible to pay off? Don’t worry—even people with lots of debt can take steps to raise their personal RI. One common way to boost your RI while dealing with high levels of debt is a debt consolidation loan, which can gather all your outstanding debt under one loan, ideally with a lower interest rate. This can make it easier to manage your payments and save you money in the long run.
Refinancing your debt is another way to lower your interest rate or decrease your monthly payment. Similar to consolidation, when you refinance a loan, you’re taking out a new loan to replace your current loan. However, keep in mind that refinancing can also mean changing the rate and length of your loan.
We all have our own financial challenges to deal with—they’re a part of life. And staying on top of debt can be overwhelming for even the most financially responsible people. But, no matter the situation, working to increase your RI with a positive mindset and a little planning can help empower you to take control of your financial stability.
Unless otherwise noted above, opinions, advice, services, or other information or content expressed or contributed by customers or non-Varo contributors do not necessarily state or reflect those of Varo Bank, N.A. Member FDIC (“Bank”). Bank is not responsible for the accuracy of any content provided by author(s) or contributor(s) other than Varo.